Robinhood is a broker. It is a FINRA-regulated broker-dealer. It relies on a clearing house to clear its transactions. The clearing house it uses is the National Securities Clearing Corporation (NSCC), which is a subsidiary of the Depository Trust & Clearing Corporation (DTCC). Thus, Robinhood is a “member” of NSCC. The NSCC is a “designated financial market utility” as defined in the 2010 Dodd-Frank Act. Thus, it is “a financial market utility that the Council has designated as a systemically important.” (“The Council” is a regulatory body created by Dodd-Frank. Its ten voting members include the Treasury Secretary, the Fed chair, and the comptroller of the currency.) NSCC is a provider of “financial market infrastructure” (FMI). As such, it must publicly promulgate rules for the computation of the “Clearing Fund” every “member” must maintain with it. While the FMI is responsible for designing its own rules for determining the clearing fund, they are subject to approval or rejection by the regulatory authorities. In particular, the SEC may prohibit any changes NSCC wants to make in its formula for computing the clearing fund of each member. The Bank for International Settlements (BIS) has promulgated a set of “principles” that member states should adhere to in regulating payment and settlement systems. These include, “An FMI should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence.”
Thus, the regulatory authorities require clearing houses to require members to keep a risk-adjusted balance with them as a guard against credit risk. In the case of Robinhood, the short squeeze drove this formulaic value up sharply. Robinhood didn’t really have much of a choice about how to respond. It had to both pony up more money for the clearing fund and act to hold off (to the extent possible) further increases in it. Robinhood had to borrow a lot of money to maintain its clearing fund.
The consternation over the stock price surges at GameStop and AMC is rooted in their disconnect with their financial performance – both companies are losing money, made worse by the pandemic lockdowns.
The other shoe is yet to drop for those who bid up the share price of GameStop, according to Indarte. “I think we’re going to see more pain felt potentially by the retail investors that are in effect bidding up the price of GameStop,” she predicted. “It’s hard to justify the prices that we’ve been seeing for the company, based on the company’s fundamentals.” In the latest quarter, GameStop reported a 30% fall in revenues to $1 billion and a loss of $18.8 million. Similarly, AMC has also shuttered most of its theaters, and recently secured $917 million in financing to stave off bankruptcy.
In addition to the soundness of its fundamentals, a company’s stock price can also be driven by investor sentiment, “but there is large heterogeneity between different companies for the importance of both,” according to Binsbergen. Much of the price discovery depends on the liquidity and the total market capitalization of the stock, he noted. Small and illiquid stocks are more susceptible to non-fundamental price movements than larger stocks, he explained.
The Committee on Financial Services of the United States House of Representatives has scheduled a hearing on “recent market volatility involving GameStop [Corporation (GME)] stock and other stocks.” The hearing will be held virtually, starting at 12 noon Eastern Time on Thursday, Feb. 18, 2021. Among those called to testify are Vladimir Tenev, CEO of online trading firm Robinhood Markets, Inc., and Steve Huffman, CEO and co-founder of social media community and online forum site Reddit.1
In addition to singling out hedge funds for criticism, it is likely that Robinhood CEO Vladimir Tenev will face hostile questioning about his company’s actions in the GameStop affair. In particular, the committee memorandum notes that payment for order flow (PFOF) has been Robinhood’s chief source of revenue since its inception and that its decision to restrict trading in GameStop and other stocks may have been influenced by its business ties to investment firms that were caught in short squeezes on these stocks.4
The committee memorandum also notes: “In December 2020, the SEC charged Robinhood with making misstatements about the firm’s receipt of payment for order flow and for failing to comply with its duty to ensure that customer trades were executed on the best possible terms. Robinhood’s failure to satisfy its best execution obligations resulted in more than $34 million in aggregate customer losses. Robinhood was censured and agreed to pay $65 million to settle the action.”
There’s just one problem: the billions of dollars in new “wealth” people have supposedly gained is mostly in the form of inflated GameStop stock. Before they can actually use that wealth, they need to convert it to cash. And if a lot of people start selling their shares, the stock will crash. Most of that GameStop “wealth” will evaporate, with many shareholders getting a fraction of the value they expected.
Meanwhile, if GameStop’s stock price starts to fall, short sellers will start to make money. Any short sellers who maintained their short positions through the bubble will make back most of what they lost.
Sooner or later, GameStop’s stock is going to return to normal levels. And when it does, we are likely to find that little wealth was actually transferred from wealthy hedge fund investors to the general public. Short losses as the stock appreciated will be largely balanced out by short gains as the stock falls. The gains of GameStop shareholders as the stock appreciates will be balanced by losses as the stock declines.
That chart ends at yesterday’s close. Things have been even more crazy overnight, with the price hitting $500/share. There have been gyrations caused by the shutdown of the chatrooms and some retail platforms stopping trading in this and other heavily shorted stocks. But the fundamental dynamic in play now–shorts slitting their own throats in panicked buying to cover–means that attempts to constrain the long herd will not have a lasting impact.
The short interest that had to (and has to) be covered is huge–short interest in GME was 140 percent of outstanding shares–and a larger share of the float. (How can there be more shorts than shares? The same share can be borrowed and lent multiple times!) The effects of the short covering are seen not only in the price, but in the stratospheric cost of borrowing shares. Earlier this week it was about 30 percent–juice loan territory. Now it is at 100 percent.
In many respects, this is reminiscent of some of the more storied episodes in Wall Street history, or more recently the 2008 VW corner which punished shorts severely. But there is a major difference. In some of the earlier episodes (including major corners of shorts in railroad stocks in the 19th century, or battles between shorts and stock pools in the 1920s, or the VW case), there was a single dominant long squeezing the overextended shorts. Here, it seems that the driving force is a relatively large group of small longs, acting with a common purpose.
First, the spectacle of the Senate wasting its time, in the middle of a pandemic, on some trading junkies maybe having not made as much money as they felt entitled to, is pathetic. It shows how warped the priorities of our putative elites are. This is secondary market trading in one bloody stock. Secondary market trading is societally unproductive (more on that shortly) and should be discouraged by increasing transaction costs (this is one of the big reasons to push for a financial transactions tax, not for revenue purposes, although that’s a nice side bennie, but to shrink the financial casinos).
The company is unimportant. The parties on both sides are competitors in a beauty contest between Cinderella’s ugly sisters: clueless new gen day traders versus clumsy shorts, many of whom look inept at the basic survival requirement of managing trading risk. And as we’ll address in due course, the real bad guy, the SEC for promoting such a socially unproductive market, has yet to receive the criticism it deserves. It’s simply bizarre that cheap market liquidity is being treated as some sort of right.
The focus has been the traders on Robinhood, a free trading platform, although some of the bigger low-cost services also had some trading halts in GameStop. These punters are surprised that a free service might not give them the best, or any execution in a bad market? Did they not work out that they were the product and having their order flow to Citadel might not be a great position to put themselves in?1Or as Financial Times reader AM put it:
It was a routine regulatory filing, the kind hedge funds must make every three months, where Melvin Capital first showed its hand.
The “Form 13F” filing that landed on August 14 last year listed 91 positions it held at the end of the second quarter, including shareholdings in household names from Microsoft and Amazon to Crocs and Domino’s Pizza. Halfway down the list: an apparently innocuous bet against GameStop, a struggling video game retailer.
That the New York hedge fund should think GameStop’s shares were going lower was hardly remarkable — many others were betting the same way. Wall Street analysts had sell ratings on the stock and the retailer’s prospects looked grim as gamers switched to downloads. But by using the options market for the bet, which forced it to disclose the position, Melvin had put a target on itself.
Writing for The Post this week, Charles Gasparino explained why the little guys got together to buy GameStop: “Mostly, they’re out to hurt the big guys.”
The Big Guys’ problem is that nobody likes them much. From Silicon Valley to Wall Street, they’re deeply unpopular with ordinary Americans, on both the left and the right, resentment they’ve stoked with selfishness, arrogance and condescension. Their solution to this unpopularity has been to use their control over online platforms, and their influence over the government, to silence their critics.
But they can’t stop the signal. No sooner did the tech giants collude to shut down Twitter alternative Parler than a new revolt sprang up somewhere else entirely among stock traders on Reddit. What will it be next? Truck drivers refusing to deliver food to Silicon Valley? Plumbers boycotting “woke” executives? It’ll probably be something cleverer and less foreseeable than that, but it’ll be something. The more the techno-elite tightens its grip, the more Americans will slip through its fingers.
The only thing “dangerous” about a gang of Reddit investors blowing up hedge funds is that some of us reading about it might die of laughter. That bit about investigating this as a “pump and dump scheme” to push prices away from their “fundamental value” is particularly hilarious. What does the Washington Post think the entire stock market is, in the bailout age?
America’s banks just had maybe their best year ever, raking in $125 billion in underwriting fees at a time when the rest of the country is dealing with record unemployment, thanks entirely to massive Federal Reserve intervention that turned a crash into a boom. Who thinks the “fundamental value” of most stocks would be this high, absent the Fed’s Atlas-like support in the last year?
This past week has been a banner one for Reddit’s island of misfit investors.
WallStreetBets exploded into the mainstream, moving from the front page of Reddit to the front page of the New York Times and nearly every other major news site. The subreddit’s short-squeeze of GameStop helped shoot up the price of the video game retailer’s stock a mind-boggling 1,700% from the beginning of January to Wednesday (before it fell again Thursday), captivating the minds and wallets of investors — both casual and institutional — and financial regulators.
But while millions are now discovering WallStreetBets for the first time, it has been building momentum throughout the pandemic. One can trace its epic rise to a perfect storm of favorable conditions: the exponential growth of the app Robinhood and its no-fee options trading, the extreme volatility Covid-19 brought to the markets, the stimulus checks mailed to millions of Americans, the lack of televised sports for much of the year, and the unwanted free time stuck at home the pandemic has forced on many people.